Why Barron's Is Right About Cisco

There aren't too many true bargains left in the market these days, with the S&P 500 index running up nearly 30% in 2013. But fear and pessimism can sometimes cause certain stocks to trade at outrageously low levels, a situation that seems to be occurring with networking giant Cisco . Over the weekend, Barron's published a positive piece on the company, citing overblown fears and a low valuation as reasons for a likely 20% return in 2014. While the size of Cisco's upside is debatable, Barron's has the right idea, and Cisco is one of the cheapest big tech stocks available today, a better value than even Microsoft and Apple .

A looming threat
The main reason for the pessimism surrounding Cisco is the rise of SDN, or software defined networking. Cisco dominates the market for networking hardware, with many customers locked in to Cisco due to the proprietary nature of its products. While Cisco includes embedded software with its networking hardware, SDN makes it possible for companies to buy commodity hardware and install third-party software, thus cutting out Cisco altogether.

SDN is not yet widespread, and Barron's estimates that meaningful adoption of the technology won't occur until 2017. But big tech firms like Google are already trying to cut out Cisco by buying switches directly from Asia, and it's possible that up to 20% of Cisco's customers could eventually try SDN, according to an independent analyst cited by Barron's. Cisco recently released a new line of switches called Insieme, a hybrid approach which allows for the freedom of SDN while maintaining the need for proprietary Cisco hardware, in an attempt to combat the rise of SDN. Cisco has stated that Insieme is actually 27% less expensive in the long-run than commodity hardware, citing strong sales of the platform as evidence that Cisco has chosen the right path.

While SDN is a real threat, it does seem overdone. It will be years before SDN goes mainstream, and Cisco is taking steps now to ensure that its market share and margins remain intact.

The cheapest big tech stock
After announcing terrible guidance last quarter, predicting an 8% decline in revenue for the quarter ending in January, shares of Cisco crashed. Now trading around $22.50 per share, shares of Cisco are a better deal than most other cash-rich tech companies, like Microsoft and Apple.

While the standard trailing P/E ratio for Cisco is about 12, and the forward P/E ratio is closer to 11, the company's massive cash reserves bring these values down to 8.8 and 8.3 respectively. These ratios reflect a dire future for the company, and the stock is seriously undervalued as long as the absolute worst-case scenario doesn't play out.

Like Cisco, Microsoft faces challenges which have the potential to upend its business model. The rise of mobile devices, along with the decline of PCs, has put pressure on both the Windows and Office businesses from which Microsoft derives a bulk of its profit. Microsoft trades at a trailing and forward P/E ratio of 10.1 and 9.75 respectively, after backing out the net cash, inexpensive for a company with serious competitive advantages, but not as cheap as Cisco.

After releasing category-defining products like the iPod, iPhone, and iPad, Apple faces dual problems. First, increasing competition from Android and Windows devices promises to have a continued negative impact on the company's margins. And second, Apple's failure to release a revolutionary new product since the iPad has led investors to question whether Apple no longer has the magic that it once had under Steve Jobs.

Apple trades at a trailing and forward P/E ratio of 10 and 9.1 respectively, after backing out the net cash. Like Microsoft, Apple appears inexpensive, but not as good a value as Cisco.

The bottom line
The threats against Cisco, while very real, have pushed the valuation down to outrageous levels. The forward P/E ratio ex-cash of 8.3 more than accounts for the threat of SDN, which Cisco is actively fighting with its Insieme line of products. While both Microsoft and Apple also seem inexpensive, Cisco offers the best value in big tech. Barron's got this one right.